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Credit - Third time's a charm
"Luck is a matter of preparation meeting opportunity." - Lucius Annaeus Seneca
As we move into 2014, our chosen title reflects the third time
strategists put forward the case for a weaker euro. So could indeed 2014
see finally the much anticipated weaker euro forecasted by so many
pundits?
In terms of our prognosis in both 2012 and 2013, we did not believe in a
weakening of the Euro versus the dollar and we reiterated our stance in
numerous occasions such as in our conversation from April 2013 "Big in Japan":
"In terms of the EUR/USD, we still think in the second quarter that
it should remain in the 1.30 region versus the US dollar, which were our
views for the 1st quarter. As we posited in January 2012, when most
strategists were bearish on the EUR/USD, the Fed swap lines in
conjunction with the FOMC decisions at the time did put a floor to the
euro and are delaying a painful adjustment in Europe. The latest decision by Japan will as well prolong the European agony. In the process the European recession can only be prolonged and the European economy will continue to suffer (unemployment rate now at 12%)."
When it comes to Europe, we will not change our stance in 2014 either. As we pointed in a "Tale of Two Central banks",
we would like to repeat our friend Martin Sibileau's view we indicated
back in October 2011 when discussing circularity issues:
"What would be a solution for the EU? We have repeatedly said it: Either full fiscal union or monetization of the sovereign debts. Anything in between is an intellectual exercise of dubious utility."
"What would be a solution for the EU? We have repeatedly said it: Either full fiscal union or monetization of the sovereign debts. Anything in between is an intellectual exercise of dubious utility."
Unless Mario Draghi unleashes in
Europe QE to fight off the growing deflationary risks we have been
tracking and warning about, we do not see a weakening of the Euro in
2014. Therefore we do not fully agree with Bank of America Merrill
Lynch's recent take on the subject in their note entitled "Will the Euro
stop defying gravity in 2014?" published on the 9th of January:
"Our case for a weaker Euro in 2014...
We argue that real economic indicators, inflation differentials, rate
differentials, technicals and quant analysis, all point towards a
weaker EURUSD in 2014. Indeed, we project EURUSD at 1.25 by the end of the year.
Our analysis suggests that the strength of the Euro in 2013 was because
of forces that are either losing steam, or will be absent in 2014,
including: the Fed’s much more dovish monetary policy stance, the
substantial adjustment from short Eurozone positions in FX and in
European assets more broadly, and an improving current account balance
in the Eurozone.
..and the case against us
The risks to our thesis for a weaker EUR in 2014 include: a slowing in US growth, a reduction in the inflation differential between the Eurozone and the US and an increase in the Euro share of global central bank reserves. We argue that these are low probability risks." - source Bank of America Merrill Lynch.
But, where we agree with Bank of America Merrill Lynch's take on the
subject is no doubt on the importance of central bank policies, which
are indeed the driving force behind many markets:
"In our view, one of the key forces supporting the Euro is relative
monetary policies. Although both the Fed and the ECB loosened policies
last year, the Fed remains much more accommodative. Indeed, the Fed has
been reluctant to exit quantitative easing too early, while the ECB has
been avoiding quantitative easing all along (see Global Rates &
Currencies Year Ahead).
Relative central bank policies would actually justify an even
stronger Euro. The strengthening of the EUR/USD during 2013 is
consistent with the expansion of the Fed's balance sheet compared with
that of the ECB (Chart 16).
Indeed, this correlation would be consistent with EUR/USD at 1.45. A comparison of the monetary policy stance between the Fed and the ECB based on a Taylor rule would justify a similarly strong EUR/USD (Chart 17).
We expect the ECB to continue being reactive rather than pre-emptive
in 2014. We believe that the ECB will deviate from its current stance
and loosen policies further only in risk scenarios, primarily linked to
disinflation and deflation risks, such as:
-If liquidity conditions were to tighten further and for a larger
number of banks in the wake of uncertainty generated by the bank asset
quality review and the stress test that will follow. In this case, we
expect the ECB to introduce a new LTRO, for more than a year and with
fixed rate (possible within H1);
-If inflation was to stay below 1% for more than a quarter and 2015
projections were to decline towards 1%. We would then expect the ECB to
cut by a small amount its refi and possibly its deposit rate (unlikely
before Q2);
-If the euro zone was to show outright signs of deflation. Only in
this case we would expect the ECB to move to asset purchases (most
likely government bonds), a tail risk scenario in our view."
After all, the "Growth divergence between US and Europe? It's the credit conditions stupid...", it is all about Stocks versus Flows. Yes, we ramble again in 2014:
"We mentioned the problem of stocks and flows and the difference between the ECB and the Fed in our conversation "The European issue of circularity",
given that while the Fed has been financing "stocks" (mortgages), while
the ECB is financing "flows" (deficits). We do not know when European
deficits will end, until a clear reduction of the deficits is seen,
therefore the ECB liabilities will have to depreciate."
When it comes to depreciation of liabilities and deflationary forces,
credit conditions in Europe have yet to improve, as bank credit to
companies and households in the euro area has shrank for the 19th month
in November even after the ECB rates cut in 2013 while euro inflation
has been below the 2% target for the last 11 months.
We have argued that improving credit conditions and severing the link between banks and sovereigns would amount to "squaring the circle".
European Banking Union or not, we do not see it happening. Credit
dynamic is based on Growth. No growth or weak growth can lead to
defaults and asset deflation which is what we are seeing in Europe and
what a 0.8% inflation rate is telling you. It is still the "D" world
(Deflation - Deleveraging). As illustrated by Bank of America Merrill
Lynch's graph from their note from the 6th of January entitled "The
mixed blessings of better markets", we have yet to see any meaningful
loan growth in the euro area and with the upcoming AQR in 2014 with
continued deleveraging, don't expect improvements anytime soon:
And when it comes to the deflationary trajectory and continued
deleveraging pressure the evolution of nonperforming loans in peripheral
countries are clearly indicate of ECB liabilities having to depreciate
further. The graph below from the previously quoted Bank of America
Merrill Lynch note clearly underlines the issues faced by the ECB, which
cannot sustain both the demand for sovereign government bonds and
credit availability for the private sector, something will have to give
unless Mario Draghi comes up with new "unconventional" tricks in 2014:
In relation to government bonds holdings, as we posited in our last 2013
conversation, it is after all, all about the carry which remains
attractive for peripheral banks which have been soaking up on their
domestic bonds at a rapid pace for the last couple of years. Third
time's a charm as well when it comes to the carry trade.
The European bond picture, some convergence as of late, with Italy and
Spanish continuing to perform and providing carry and earnings to their
respective financial institutions - graph source Bloomberg:
Some additional convergence as well can be seen credit wise in the
evolution between the spread of the 5 year CDS index Itraxx Main Europe
(Investment Grade risk gauge based on 125 European entities) and the 5
year Itraxx Financial Senior index which has been trending towards zero -
graph source Bloomberg:
With so much "Greed" and no "Fear", risky assets have rallied hard at
year end, particularly in December, as displayed in the rally seen in
High Yield and the continuous rally in the S&P 500, but increasingly
the performances for credit investment grade is being capped - graph
source Bloomberg:
The surge in risky assets has been of course driven by the fall in volatility as a whole in various asset classes as displayed in the below Bloomberg graph although the recent announcement of "tapering" in December has led to a surge in 1 month Treasury options volatility as of late:
CVIX index = DB currency implied volatility index: 3 month implied volatility of 9 major currency pairs.
EM VYX index = JP Morgan EM-VXY tracks volatility in emerging market
currencies. The index is based on three-month at-the-money forward
options, weighted by market turnover.
Of course, credit has not been the shining star of 2013 as it was the
shining star of 2012. In 2013 the S&P500 delivered its best return
since 1997.
The rise of the S&P 500 a story of
growing divergence between the S&P 500 and trailing PE since January
2012 - graph source Bloomberg:
Of course 2014 is already a continuation
of 2013 in terms of multiple expansions when one looks at the recent
announcement of FedEx which will issue $2 billion of bonds to speed up
stock buybacks. While shareholders have been celebrating, bondholders
have no doubt been licking their wounds given that FedEx’s $500
million, 4.1 percent portion due April 2043 and issued last year traded
Dec. 18 at 86.2 cents on the dollar to yield 5 percent, according to
Trace, the bond-price reporting system of the Financial Industry
Regulatory Authority and as reported by Bloomberg. For Apple's long bond
issued last year it is a similar story of bond losses.
The "Cantillon Effects"
at play, the rise of the Fed's Balance sheet, the rise of the S&P
500, the rise of buybacks and of course the fall in the US labor
participation rate (inversely plotted) - source Bloomberg:
In red: the Fed's balance sheet
In dark blue: the S&P 500
In light blue: S&P 500 buybacks
In purple: NYSE Margin debt
In green: inverse US labor participation rate.
In light blue: S&P 500 buybacks
In purple: NYSE Margin debt
In green: inverse US labor participation rate.
As we posited in our conversation "Misstra Know-it-all":
"By suppressing interest rates through ZIRP, the Fed has allowed
risks to be "mis-priced" leading to global aggressive "mis-allocation"
of capital in the search for returns."
In terms of the "dash for trash", it can be illustrated we think by looking at the performance of Small-Cap, Utility Stocks versus the S&P 500 since December 2012 - graph source Bloomberg:
Or by looking at the S&P500 index versus High, Low Quality Stocks since March 2009 - graph source Bloomberg:
Looking at the S&P 500 against Margin Debt at NYSE members firms and
the estimated annual interest cost for margin debt at broker call rate,
we wonder at what point this rally induced more and more by leverage
players will come to an abrupt end - graph source Bloomberg:
And looking at the success by the Fed in "bending" the velocity curve and curbing the fall in the labor participation rate, we wonder if playing the "wealth effect" via asset prices inflation is worth the risk being taken - graph source Bloomberg:
What investors fail to assess is the growing global deflationary risk which, we agree with CLSA Strategist Russell Napier, is significant:
“Investors are cheering the direct impact of QE on their equity
valuations, but ignoring its failure to produce sufficient nominal-GDP
growth to reduce debt. In a market where such bad news has been seen as
good news (as it leads to more QE), the reality of QE’s failure will
become bad news as we head towards deflation ….. The failure of monetary
policy to defeat deflation is about to become apparent, with dire
consequences for equity prices”. - CLSA Strategist, Russell Napier
Just note that the ThomsonReuters/Jefferies Commodities Index is now back to where it was at the end of 2009 and 25% below its early peak in 2011. Of course Gold's 28% decline in 2013 has been the worse since 1981.
Of course one of the principal culprit in exporting deflation on a global scale, has no doubt been Japan, as we have posited back in 2013. For the first time since 1992, as reported by Bloomberg, prices in Japan's consumer durables are indicating somewhat a tentative escape from the deflationary forces which have been plaguing for decades Japan - graph source Bloomberg:
"Prices in Japan of consumer durables such as computers and mobile
phones rose for the first time since 1992, signaling progress in the
nation’s campaign to defeat deflation.
The CHART OF THE DAY shows a 0.3 percent gain in November from a year earlier, after a 21-year slide, boosted by price increases for desktop and notebook computers. The gauge has a weighting of about 7 percent in the overall consumer-price index, which rose 1.5 percent.
The increase came seven months after the Bank of Japan unveiled record monetary easing in pursuit of a 2 percent inflation target. The jump defies a trend of technological improvements leading to lower prices and shows manufacturers are moving away from aggressively competing on cost, according to economist Yoshiki Shinke.
“Inflation is spilling across a whole range of products,” said Shinke, chief economist at Dai-ichi Life Research Institute in Tokyo. “The weakening yen has contributed to higher prices for these products as Japan is importing many final goods given that production is shifting overseas.”
Declines in the Japanese currency, which fell last month to its lowest against the dollar since 2008, led companies such as Apple Inc. to raise prices last year of computers and smartphones. Increases of 24 percent and 12 percent for desktop and notebook computers, respectively, in the November consumer- durables data outweighed a 0.3 percent fall in auto prices.
The narrower household durables index, which includes refrigerators and washing machines, fell 0.9 percent. Technological advances for such appliances lag behind those for gadgets, holding back demand and price gains, according to Naoki Murakami, chief economist at Monex Inc. in Tokyo." - source Bloomberg.
On a final note, as we posited in our conversation from December 2013 "All that glitters ain't gold", we still believe the following:
"2014 will also see Europe still facing the pressure from two tectonic deflationary plaques, which have been the US QE but more importantly in 2013 the outpacing of the Fed led by "Abenomics" which is indeed sending a tremendous deflationary force around the world which means that even the US is not immune to, hence our repeated doubts in seeing a "tapering" in 2014."
Therefore unless, the ECB starts another round of QE or some additional "unconventional" policies, with Japan exporting deflation on a global scale, and the recent lackluster US nonfarm payroll numbers, we have a hard time seeing a much lower EUR/USD for the time being.
"Faith consists in believing when it is beyond the power of reason to believe." - Voltaire
Stay tuned!
Just note that the ThomsonReuters/Jefferies Commodities Index is now back to where it was at the end of 2009 and 25% below its early peak in 2011. Of course Gold's 28% decline in 2013 has been the worse since 1981.
Of course one of the principal culprit in exporting deflation on a global scale, has no doubt been Japan, as we have posited back in 2013. For the first time since 1992, as reported by Bloomberg, prices in Japan's consumer durables are indicating somewhat a tentative escape from the deflationary forces which have been plaguing for decades Japan - graph source Bloomberg:
The CHART OF THE DAY shows a 0.3 percent gain in November from a year earlier, after a 21-year slide, boosted by price increases for desktop and notebook computers. The gauge has a weighting of about 7 percent in the overall consumer-price index, which rose 1.5 percent.
The increase came seven months after the Bank of Japan unveiled record monetary easing in pursuit of a 2 percent inflation target. The jump defies a trend of technological improvements leading to lower prices and shows manufacturers are moving away from aggressively competing on cost, according to economist Yoshiki Shinke.
“Inflation is spilling across a whole range of products,” said Shinke, chief economist at Dai-ichi Life Research Institute in Tokyo. “The weakening yen has contributed to higher prices for these products as Japan is importing many final goods given that production is shifting overseas.”
Declines in the Japanese currency, which fell last month to its lowest against the dollar since 2008, led companies such as Apple Inc. to raise prices last year of computers and smartphones. Increases of 24 percent and 12 percent for desktop and notebook computers, respectively, in the November consumer- durables data outweighed a 0.3 percent fall in auto prices.
The narrower household durables index, which includes refrigerators and washing machines, fell 0.9 percent. Technological advances for such appliances lag behind those for gadgets, holding back demand and price gains, according to Naoki Murakami, chief economist at Monex Inc. in Tokyo." - source Bloomberg.
On a final note, as we posited in our conversation from December 2013 "All that glitters ain't gold", we still believe the following:
"2014 will also see Europe still facing the pressure from two tectonic deflationary plaques, which have been the US QE but more importantly in 2013 the outpacing of the Fed led by "Abenomics" which is indeed sending a tremendous deflationary force around the world which means that even the US is not immune to, hence our repeated doubts in seeing a "tapering" in 2014."
Therefore unless, the ECB starts another round of QE or some additional "unconventional" policies, with Japan exporting deflation on a global scale, and the recent lackluster US nonfarm payroll numbers, we have a hard time seeing a much lower EUR/USD for the time being.
"Faith consists in believing when it is beyond the power of reason to believe." - Voltaire
Stay tuned!